Despite the euphoric market reaction to
Labour's landslide victory in last year's general election -- and
the immediate granting of operational independence to the Bank of
England -- UK Gilts are still yielding over 100bp more than German
Bunds.

Given the strong position of the UK government finances and
the powerful economic fundamentals in the country, analysts and
traders believe this spread is far too high.

And international investors have been quick to take
advantage, pouring money into a Gilt market whose structure has
been substantially improved by nearly four years of rolling
reform.

Forward spreads imply much greater convergence, suggesting
confidence that the UK will eventually be part of Emu and that the
UK's economic strength merits a much closer spread to
Germany.

But there is also a risk that UK institutional money may
start to desert the UK government debt market in favour of the more
liquid investment alternatives in the new euro-land. In that case,
say sceptics, the lack of new supply may render the Gilt market as
little more than an illiquid, irrelevant backwater.

In the week following the UK's general election of May 1 last
year -- which saw Labour sweep to power with a huge majority --
Prime Minister Tony Blair and his new cabinet virtually redefined
the expression "honeymoon period".

A decade or so ago, the idea of a Labour Party controlling the
UK's purse strings almost certainly by adopting the old
tax-and-spend policies would have plunged the City into the depths
of despair. This time around, it greeted New Labour with open
arms.

By May 7, the Labour Party, once a demon in the eyes of the
City, had London-based economists virtually purring with a
combination of delight and relief.

As Morgan Stanley noted towards the end of the first week of
May, "pre- and post- election worries about a Labour Party victory
in the UK's general election on Thursday, May 1 evaporated in about
half a day's trading the following day. By May 6, both bond and
equity markets were giving a unanimous 'thumbs up' to the
resounding Labour victory."

"Our contention," continued the euphoric bulletin, "that this
Labour Party is the most market-friendly Labour Party the UK has
ever seen has been backed up by Gordon Brown's immediate move to
increase the independence of the Bank of England -- an early and
reasssuring move to show that inflation is a priority for this
government."

Others were equally delighted, but also stunned, by the speed
with which Chancellor Brown acted and by the powerful Gilts rally
which followed. As Salomon Smith Barney concisely noted on Friday,
May 9: "Tuesday's rally was so fast that many investors missed
it."

It was not just the Bank of England's independence which was
greeted with euphoria by the markets. Unashamedly taking a leaf out
of a book written on the other side of the planet -- in New Zealand
-- Chancellor Brown also announced, in the words of a press release
from the UK's Treasury, that "the Bank of England's role as the
government's agent for debt management, the sale of Gilts,
oversight of the Gilts market and cash management would be
transferred to the Treasury."

There is, however, a limit as to how far the enthusiastic
back-slapping for what Labour has achieved for the Gilt market can
go, for two obvious reasons.

In the first place, as one London-based banker points out, Bank
of England independence was in some respects the icing on the cake
for the Gilts market following four years of rolling reform
initiated under the old political administration.

Second, if what has been achieved in the Gilts market since the
general election is measured in the most brutal and analytical way
-- in other words in terms of basis points -- precious little has
been won. Following the euphoric aftermath of the post-election
announcement and the tumbling of the Gilt-Bund spread which
accompanied it, the differential between the UK and Germany has
remained surprisingly high in the eyes of many analysts.

As one says, "with the spread at 100bp plus, there's clearly
scope for massive tightening. If you ask what is the correct spread
for Gilts over Bunds you could argue that it would be zero or even
negative."

"It is probably a matter of some concern and disappointment to
the government that its debt servicing costs on a spot basis are
still more than 100bp more than Germany's," says David Boal, vice
president in the Gilts department at JP Morgan in London.

"People are asking themselves: how can this be when the UK has
probably got the lowest debt to GDP ratio of any major European
economy, together with a very low deficit which is probably heading
for a surplus next year?

"And how can this be when we have seen Gilt market reforms
leading to regularised auctions, the introduction of repos and
strips, the removal of anachronisms such as the special ex-dividend
and the move towards making the market decimal? In spite of all
this -- twinned with the strong state of the government's finances
-- we still have not seen a big compression in yield spreads versus
core Europe."

In some respects, the government and the new Debt Management
Office (DMO) need not lose too much sleep over the stubbornly
yawning gap between Bunds and Gilts, for a number of reasons.

First, forward spreads make decidedly better reading, with the
five year forward spreads at 25bp over Germany and 10 year forward
Gilts trading through the Bunds.

"So looking ahead the market is already pricing in the good UK
economic fundamentals and to some degree rewarding the UK market
for better transparency and efficiency in the Gilts market," says
Boal.

In reflection of these forward spreads, nobody seems to imagine
that the Gilt-Bund spread will stay in three digit territory for
long. In its fourth quarter review of the sterling bond market, for
instance, SBC Warburg Dillon Read predicted a six month fall in the
spread to Bunds to 73bp, and a 12 month fall to 49bp.

Salomon Brothers also foresees a fall in the UK-German spread,
commenting in its first quarter outlook that "the Gilt-Bund spread
is likely to plunge to about 0.6% by the end of 1998."

In a number of other respects, however, bankers do believe that
the government should at least be alive to some of the concerns
unrelated to the macroeconomy which are implicit in Gilt yields
today.

At Barclays Capital, for instance, Gilts head Euan Harkness
points out that there may well be a double edged sword to the
so-called rarity value of Gilts. "Going into 1999 there must be a
slight concern that the Gilt market will go into a cul-de-sac if it
becomes too exotic and too illiquid," he says.

This concern appears well founded enough. While it is all very
well to see sterling as a diversification opportunity in a world
soon to be dominated by dollars and euros, this is countered by the
fact that the sterling market may become so small in relative terms
following the start of Emu that it becomes peripheral to the point
of being irrelevant.

The danger -- and this a theme often harped upon by Britain's
Eurosceptics -- is that in spite of the contraction in the supply
of UK Gilts, the competition from the much larger and more liquid
government bond market in euro-land will more than compensate for
this, leading to a net outflow of institutional money.

"Traditionally," says one analyst, "the UK was able to rely on a
very large pool of domestic assets which were channelled more or
less automatically into the Gilt market. But in the UK we have
outstanding debt representing about 55% of GDP and a pension
industry with assets covering almost 100% of GDP. Germany does not
have anything like these assets in its pension funds, and the worry
is that you will see Germany being a net beneficiary of flows of UK
pension money."

All the more reason, say bankers, for the UK to ensure that it
does everything within its power to maximise the efficiency of its
Gilts market -- which bankers say still leaves something to be
desired.

"I think we have a very good government bond market now in terms
of its structure," says Boal, "but investors, especially foreign
investors, still complain about illiquidity -- they still complain
that the Gilt market does not give them as good a bid-offer spread
as they see in the Bund market."

This, say Gilt market analysts, is primarily a reflection of
enduring problems with the hedgeability of Gilt positions for
primary dealers.

"A very palpable instance of where hedging has been difficult
over recent months," says one, "has been the squeeze on the 09/08
Gilt.

"That arose because there was no nearly adjacent issue in terms
of value which made it very easy to squeeze the 09/08 again and
again because people were unable to substitute anything else for
it."

This analyst adds: "The remedy for that is to change the
specification of the futures contract which is what Liffe has done,
but we would certainly hope that one of the main roles the new DMO
will play will be to make sure that Gilt squeezes are not allowed
to impair market efficiency in the future." EW